WATER SOURCING AND PRICING

• Jurisdiction: United States

Water Acquisition and Management for Oil & Gas Development
(Apr 2016)
CHAPTER 6A
WATER SOURCING AND PRICING
Aileen M. Hooks ¹
Partner
Baker Botts LLP.
Austin, TX

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AILEEN M. HOOKS is a Partner with Baker Botts LLP. in Austin, Texas. She serves as the Firm-wide Deputy Department Chair of Baker Botts' Environmental Practice. She negotiates and manages the environmental and facilities-related aspects of clients' projects and transactions in the United States and globally. In particular, Ms. Hooks has considerable experience advising clients on environmental and safety regulatory developments and issues and liability considerations affecting the full spectrum of the energy industry. She has experience working on water transactions in the oil and gas and other industries, including representation of oil field service companies on water projects and transactions. She also regularly provides legal counsel to clients on environmental, health and safety regulatory, permitting, and enforcement matters. She provides strategic advice to clients on matters before state and federal agencies, including the Texas Commission on Environmental Quality, the Railroad Commission of Texas, and the U.S. Environmental Protection Agency. Ms. Hooks received her BSFS in International Finance & Commerce from Georgetown University and her JD from the University of Texas many years ago.

Water Sourcing and Pricing: Understanding the Building Blocks for Transactions to Supply Water for Oil and Gas Production

The increase in the use of hydraulic fracturing to support shale development has led to an exponential rise in the demand for water for oil and gas production due to the increased intensity of water use for hydraulic fracturing.² The market to meet this increased demand has been evolving in response as has the reaction of entities with regulatory oversight over water management. Similarly, the nature and terms of agreements to provide water to the oil and gas industry are adapting to the changed market environment.

This paper addresses some of the basic underpinnings of water transactions to meet the needs of the oil and gas industry - namely, the potential types of sources, the suppliers of those sources, and pricing and payment considerations. The foundation of a transaction to acquire a supply of water needed for oil and gas production, particularly the more water-intensive hydraulic fracturing associated with horizontal drilling in shale formations, is a reliable and adequate source of water that is available for use as and when needed. The price and structure of payment terms are also important elements of the transaction. And one of the key connectors between the water source and the pricing of the water is the identity of the water supplier. Water sourcing, suppliers and pricing are influenced by a number of factors, including history, geography, weather and neighbors, and water markets for the oil and gas industry will vary by state and region. But there are common underlying themes. To discuss those themes, this paper focuses on the Texas legal framework and market.

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Moreover, the marketplace for water generally may be undergoing a potentially transformational shift. In 2011, Willem Buiter, an economist with Citigroup made the following forecast about the future for a world marketplace for water:

I expect to see a globally integrated market for fresh water within 25 to 30 years. Once the spot markets for water are integrated, futures markets and other derivative water-based financial instruments -- puts, calls, swaps -- both exchange-traded and OTC will follow. There will be different grades and types of fresh water, just the way we have light sweet and heavy sour crude oil today. Water as an asset class will, in my view, become eventually the single most important physical-commodity based asset class, dwarfing oil, copper, agricultural commodities and precious metals. ³

However, the current state of the water market in the United States is based on a local framework that has not achieved national, much less global, integration. And, as discussed below, this market largely operates with imperfect information and a lack of transparency and centers around a product that can be classified, at least in some respects, as common pool resource or public good. In short, water transactions today do not occur in a typical commodity market with transactions based on standard contract terms.

A. Sourcing Considerations

"Location, location, location" is a crucial factor in water transactions much as it is in real estate transactions, including the proximity of the water source to the drill site and, if needed, a means of suitable transport to get the water to where it's needed. In Texas, the overlay of governmental regulation and policy on the private use rights for surface water and private ownership of groundwater are important factors in the sourcing of water. For example, there may be restrictions on where surface water or groundwater may be used as well as restrictions based on the priority of a surface water right.

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It is generally recognized that the two basic sources of water supply for oil and gas production in Texas are surface water and groundwater. While there is not a distinct regulatory requirement for an oil and gas operator in Texas to report the source of the water it uses, based on reported information in the Barnett Shale, the water used for oil and gas production is approximately half surface water and half groundwater.⁴

In Texas, surface water is for the most part synonymous with "state" water,⁵ which includes "[t]he water of the ordinary flow, underflow, and tides of every flowing river, natural stream, and lake, and of every bay or arm of the Gulf of Mexico, and the stormwater, floodwater, and rainwater of every river, natural stream, canyon, ravine, depression and watershed in the state" and "water imported from any source outside the boundaries of the state for use in the state and which is transported through the beds and banks of any navigable stream within the state or by utilizing any facilities owned or operated by the state."⁶ Additionally, state water injected for underground storage as part of an aquifer storage and recovery project remains state water. In contrast, percolating groundwater, generally referred to as groundwater, and described in Texas case law as "underground waters percolating, oozing, or filtering through the earth,"⁷ is not state water.

As is typical in the western U.S. states, the Texas legal framework for water rights is based on prior appropriation and correlative rights. Texas generally allocates the rights to use surface water using a prior appropriation and permit framework. An exception to this approach can be found in a large portion the Rio Grande basin where surface water rights, for historical

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reasons, are allocated based on correlative rights and managed by a watermaster.⁸ Groundwater rights in Texas are tied to land ownership, but like mineral rights may be severed from, and transferred independently of title to, the land. Use of groundwater is based on the rule of capture. Under the rule of capture, the owner of the groundwater rights is able to drill for and pump as much water as he or she can absent waste, malicious drainage of another's property or negligently causing subsidence.⁹

Regulation of the withdrawal and use of groundwater in Texas has become more prevalent, however. For land situated within the jurisdictional boundaries of one of the 101 groundwater conservation districts in Texas as of January 2016, the rule of capture may be constrained by the rules of the groundwater conservation district. Groundwater conservation districts are authorized to protect and manage groundwater in their jurisdictions to maintain supply in the area. State legislation creating groundwater conservation districts provides that such districts are "the state's preferred...